Sunday, March 26, 2017

Bringing back the Somali shilling

Somalia has long played host to one of the world's strangest monetary phenomenon, a paper currency without a central bank. I explored the idea of Somalia's "orphaned currency" more fully four years ago, but if you're in a rush what follows is the tl;dr version. Despite the fact that both the Central Bank of Somalia and the national government ceased to exist when a civil war broke out in 1991, Somali shilling banknotes continued to be used as money by Somalis. Over the years, Somalis also accepted a steady stream of counterfeits that circulated in concert with the old official currency, a state of affairs that William Luther explores in some detail here.

The story is worth revisiting because apparently Somalia's newly restored central bank is on the verge of re-entering the game of printing banknotes after a quarter century absence. With the help of the IMF, the Central Bank of Somalia (CBS) plans to issue new 1000 shilling banknotes, the introduction of higher denomination notes coming later down the road.

Old legitimate 1000 shilling notes and newer counterfeit 1000 notes are worth about 4 U.S. cents each. Both types of shillings are fungible—or, put differently, they are accepted interchangeably in trade, despite the fact that it is easy to tell fakes apart from genuine notes. This is an odd thing for non-Somalis to get our heads around since for most of us, an obvious counterfeit is pretty much worthless. The exchange rate between dollars and Somali shillings is a floating one that is determined by the cost of printing new fake 1000 notes. For instance, if a would-be counterfeiter can find a currency printer, say in Switzerland, that will produce a decent knock off and ship it to Somalia for 2.5 U.S. cents each (which includes the cost of paper and ink), then notes will flood into Somalia until their purchasing power falls from 4 to 2.5 U.S. cents... at which point counterfeiting is no longer profitable and the price level stabilizes.

Below is the long-term price of Somali shillings, which I've snipped from Luther's paper. You can see how the purchasing power of a 1000 shilling note has fallen to what Luther calculates to be the cost of producing a new banknote, around 4 cents. His chart goes up to 2013, but if you look at the IMF's most recent report on Somalia (see Figure 3) you'll see that the exchange rate hasn't moved much.

So with a new official banknotes on the way, what will happen to the old legacy notes and counterfeits? According to the IMF mission chief Mohammed Elhage, the IMF is in the midst of trying to determine at what price it will convert old notes for new official ones. So rather than repudiating counterfeits, the normal route taken by central bankers, the CBS will buy them up and cancel them. It will have to offer a decent price too, say like 5 or 6 U.S. cents for each 1000 note. If it makes a stink bid, say 3 U.S. cents, Somalis may simply ignore the appeal to bring in their old currency and keep using the old stuff. Because the buyback decision validates the work of counterfeiters, it just seems wrong. However, keep in mind that for the last twenty-five years it has been counterfeiters who have been willing to take on the risk of providing Somalis with a very real service, the provision of a working paper medium of exchange.

There is another good reason for buying up old legacy notes and counterfeits and cancelling them. If the CBS lets the old notes stay in circulation, then Somalia's ragtag multi-currency system will only get more confusing, with old legacy and counterfeit notes circulating concurrently with new shillings and U.S. dollars. With the new issue of shillings having a different purchasing power than the old ones, yet another floating exchange rate will be added to the mix. Who needs that sort of confusion? Better for the CBS to absorb the cost of buying up fakes in order to promote a more homogeneous currency.

***

As I pointed out in my old post, there's an old and nagging question in monetary economics that has never been satisfactorily answered: why is fiat money valuable? Somalia serves as a great laboratory to investigate this question because its situation is so unique. One famous answer to the riddle of fiat money is that governments use force to ensure that fiat money is valued. But this can't be the case in Somalia: it hasn't had a government since 1991, yet shillings continue to be accepted.

A second answer is that once money is valued—say because it a central bank has been pegged to an existing store of value like gold—then once the central bank disappears and the anchor is lost, those orphaned notes will continue to have value by dint of pure inertia and custom. This theory certainly seems to fit Somalia's experience.

The last theory is that when a central bank is destroyed, the money it issues will quickly become worthless... unless citizens expect a future central bank to emerge and reclaim the orphaned currency as its own. If so, it makes sense to keep using the currency since it isn't actually orphaned—it's on the way to being adopted. If the expectation is that this future central bank will also adopt counterfeit notes, it makes sense for people to accept all knock-offs as well. So we can tell a story that shillings, both real and fake, never fell to zero because enough Somalis had a hunch that a future body would reclaim them, a hunch that is on the verge of being realized as a newly-christened CBS seems set to buy old and fake shillings back. Were Somalis really this good at predicting the future? I don't know, but like the second theory, the last one seems to explain the data.

***

Personally, I think introducing a new paper currency is a bad idea. For some time now Somalia has been partially dollarized economy. U.S. dollar banknotes are the most popular paper currency, with old shillings being used in small payments and in the countryside. Mobile payments are extremely popular, but they are usually denominated in U.S. dollars, not shillings, and tend to be prevalent in cities where network coverage is best.

There are several problems with dual-currency systems like Somalia's. First, they impose a small but steady stream of currency conversion costs on the population, both the actual cost of shifting one's wealth from one to the other as well as the mental gymnastics involved in converting prices in one's head. Secondly, there are fairness issues. Civil servants are usually paid in the domestic currency and those in rural parts deal in the stuff. Urban private sector workers tend to earn dollars. In developing nations, dollars are usually more stable than domestic currency. As a result prices of houses, cars, and rent are often set in dollars. The class of folks who are paid in dollars make out better than the class that is earning shillings. Dollar earners never have to leave the much stabler dollar loop while those earning domestic currency suffer from constant slippage due to conversion costs and chronic inflation.

Now the IMF might argue that new shillings will completely expel dollars, thus forcing everyone into the same shilling loop and removing any monetary inequalities. But that's hog wash. The literature on dollarization teaches us that once the dollar begins to be used by a country—usually because the domestic currency has suffered from high inflation—it is very hard to remove it. Long after the local currency has been successfully stabilized, dollarization continues, an effect referred to by economists as hysteresis. Bring back the shilling and the dollar will stick around.

While bringing back new shillings doesn't make much sense, some sort of currency reform is probably worthwhile. While cities seem to be already well-served by dollars and mobile money, the rural population still relies on old and deteriorating shilling notes. Instead of foisting new shillings on these people, why not replace them with locally-minted small denomination dollar coins? I call this the Panama solution. For those who don't know, Panama is a dollarized nation. Due to the high costs of shipping in coins form the U.S., Panama mints its own dollar-denominated small change, paper money printed by the Federal Reserve taking care of the rest of the nation's physical money requirements.

By adopting the Panama model all Somalis would get to deal in U.S. dollars, thus removing any monetary class divisions. Gone too would be the headache of constantly converting between shillings and dollars, since with U.S. coinage there would only be dollars. And poor Somalians living in rural areas without phone coverage would finally get clean and homogenous small denomination cash.

Admittedly, there's far less for a central banker to do if he/she issues a narrow range of small denomination U.S. denominated coins, say 1¢, 5¢, and 25¢, rather than a full range of banknotes. It's certainly not sexy. But it would be cost effective. Coins, after all, last much longer than notes. This
durability means that coins are a cheaper circulating medium for a
central bank to maintain than paper. There is also the national ego that must be satisfied. What nation doesn't have its own currency? The worst reason to adopt a new shilling is because some concept of nationhood requires it—Panama has been using the dollar for decades, and this hasn't prevented it from becoming one of Central America's most successful nations.

32 comments:

"There is also the national ego that must be satisfied. What nation doesn't have its own currency?"

You seem to have rediscovered UKIP's (pre-Brexit era) anti-euro argument here. Fortunately there are a bunch of other countries in Europe mature enough not to be stopped by this. (other anti-euro arguments based on optimal currency areas and flexibility may be more legitimate...)

Value doesn't disappear overnight. In fact, the disappearance of the producer of money would tend to make it more valuable as they are still held and something must be used. Counterfeiters are an interesting case as they would lower the value. I wonder who first accepted it and whether the counterfeiter had to assure they would accept it in return. Perhaps being so close to production value limited the value of counterfeiting. I wonder if the problem with dollars is they come in too large of denominations to be useful to the users of it. Pennies would work at that level, but perhaps not at lesser levels. Coins would seem to make more sense but even the US loses money on low value coinage. The problem may be they are at the commodity bound with no means of producing money of such low value.

As I pointed out in my old post, there's an old and nagging question in monetary economics that has never been satisfactorily answered: why is fiat money valuable?

Haven't you answered your own question? A medium of exchange is, as you say, a valuable service in itself. The answer to "why does it have value?" is that it beats the alternatives. The alternatives are either doing everything with store credit, barter, or cigarettes, which is evidently much worse than using money, or else using foreign currency (probably but not necessarily dollars), which is fine if you have dollars.

Sure, people counterfeit, but in the context of modern Somalia, you have other things to worry about than inflation:-)

Perhaps I should have stated it differently. The nagging question is: how does positively-valued fiat money emerge?

There are three theories. 1. The government forces it on the population 2. It is linked to a commodity but when that link is severed the valuable services it is already providing give it enough momentum to continue as a fiat currency, and 3. people expect a tether to be re-established at some point in the future.

I would argue it is a combination of 2 and 3. When fiat gets started, it must be tied to some commodity or asset. And the reason fiat currencies continue to hold value after the redemption for commodities or assets is suspended is because people anticipate that the monetary authority will either choose to, or have to, re-open those redemption channels at some point in the future.

But I think this case of the Somali shillings is a special case because counterfeiters were able to print as much of it as they liked without legal punishment, in effect turning the old shilling itself into a commodity.

I wouldn't write of #1 so quickly. Chartalists have a few examples of tax-driven currencies, or the idea of twintopt, as they like to call it. And using your wording, taxes can be thought of as a type of 'redemption channel.' [Hmmm, redemption channel: sounds like you've been reading Mike Sproul.]

But I don't think shillings were #1.

"But I think this case of the Somali shillings is a special case because counterfeiters were able to print as much of it as they liked without legal punishment, in effect turning the old shilling itself into a commodity."

If you look at the chart above it took almost two decades for notes to fall to their commodity cost. Until then, 1-3 can help explain their value.

It is reasonable to figure that an established currency does not need any backing prior to its loan contracts. In a debt based, loan contract generated currency , the deposits of private banks, the value of the currency is the economic resources sold by the borrowers to honour their loan contracts.

I think one of the first introducers of counterfeit money was Hussein Aideed's 'Somali government' in Mogadishu in the 1990s followed in the 2000s by the TNG in Mogadishu and Abdullahi Yusuf in Puntland. The latter two caused massive inflation.

I don't see why the exchange-value of the old shillings should have anything to do with whether some official institution will ever buy them back. Let's imagine that Somalis somehow knew, on good authority, that no central bank would ever buy back their old shillings for a billion years, until the sun burned out. What would happen? Nothing, I predict. The old shillings would continue to trade at around 4 cents/shilling, or whatever the cost of printing counterfeit shillings would be.

At this point, the Somali shillings are really no longer "fiat" money, but commodity-money. With counterfeit printers having gotten free-rein legally to print as much as they liked, the exchange-value of the shillings collapsed down to the exchange-value of the paper and ink of which they are made.

Holders of these shillings can now rest confident that the exchange-value of these shillings will from now on be determined, as with any other commodity, by the shilling's "production price"—the cost price of printing the shillings, plus an average rate of profit needed to incentivize some enterprising counterfeiter to finance the printing. The shilling now has an objective basis for its exchange-value, just as with any other commodity, and it matters not one iota what any government has to say about it.

Of course, if you object that the shilling is, in and of itself, useless, you'd be right. But, as we all SHOULD know (if we still paid attention to the classical economists and forgot all of this subjective theory of value nonsense), the best commodity-monies are those that have zero use-value because in that case there are no potential industrial or practical uses of the commodity that would exert fluctuating effects on the demand for the commodity. Instead, the commodity will be demanded solely for its objectively-determined exchange-value, as a representation of exchange-value.

To elaborate: let's imagine that this old shilling becomes less popular as a medium of exchange. Then its price will temporarily dip below its price of production, which will bring to a halt any further efforts to counterfeit new shillings. With the supply of new shillings no longer increasing, any revival in demand for the shilling to be used as money will bring its price back up to the price of production, or even over the price of production, at which point more shillings will be produced to drive its price back down to its production price, and so on. This is also how gold production was (and still is) regulated by Adam Smith's "Invisible Hand."

When central banks stop accepting a currency as their liability, i.e. when it is demonetized, it usually doesn't continue to circulate as money, even though it has a long history of use. An example of this is when a country suffering from high inflation replaces a currency with many 0s with one that has few 0s. Or the recent Indian demonetization. Or the demonetization of lira/francs etc to create the euro. No one keeps using the replaced notes.

The Somali situation is very much like a demonetization. The shilling effectively lost all central bank support. Except unlike a demonetization the shilling continued to circulate. Why is that? One theory is the "future central bank" theory. When news hit in 1991 that the central bank has been destroyed, Somalians decided the shilling was still usable because at some point in time, maybe the next year, a new bank would take shillings on as their liability.

25 years later, with shillings trading at their commodity cost, it makes no difference whether a future bank will buy them back, as you point out. But in 1991 it may have made a difference.

In the case of those other demonetizations, those various notes could have only continued circulating past the redemption period at their commodity values--based on the costs of the paper and ink used to print them. It is to be expected in those cases that people would much prefer to redeem those notes for a higher value instead of continuing to use them.

And like you yourself admitted, the Ethiopian central bank will probably have to offer a premium over the commodity value of the old shilling notes--perhaps 5 or 6 cents per note--in order to get people to voluntarily redeem the notes instead of continuing to use them.

The real interesting question is, why didn't any old shilling counterfeiter (who, at this point, is really just a producer of the old shilling as a paper commodity just like a gold miner is a producer of gold) try to add a bunch of 0s to their notes? That way, they could only spend 4 cents/note to produce something with a thousand or a million or a trillion times the face-value.

My guess: because there were no such official denominations before, and they would stick out as being obvious fakes. Whereas it appears that, for the counterfeit old notes to circulate along with the real old notes, some plausible deniability was needed. Even if everyone "knows" that there are a bunch of fakes floating around, and even if it seems trivial to spot them, perhaps they were missing the level of "not everyone knows that everyone knows...etc."

"But why should it matter whether the fakes are clearly distinguishable?" Well, why did it used to matter that gold money was real gold and not fool's gold? Back when gold was a medium of exchange, why didn't fool's gold, a substance with practically the same useful properties (color, appearance, etc.), get substituted for real gold as money? Likewise, why wouldn't Somalis embrace a new type of counterfeit note with a few extra 0s on the end as just as legitimate? Whatever the curious answer is, it's the same in each case.

"once the dollar begins to be used by a country—usually because the domestic currency has suffered from high inflation—it is very hard to remove it."

No, you just ban use of USD. If the government is strong enough to enforce the ban, it will work. Weakness of government is the independent variable here. Even in 1998-99 USD were not accepted in Moscow for anything other than gypsy cab rides.

Good point, Also I'll say all of the theories you present can be simultaneously true.

About this point: yeah, people don't know what money is and are confused about it, so they continue to hold the notes. I've seen people claiming that currency notes have a silver/gold strip whose value is exactly equal to the value printed in the notes.

Over the 5 years that I worked on and off in Mogadishu, I found that 98% of transactions were all done from mobile to mobile with no need for hard currency. Hilariously, the only time individuals insisted on using the shilling was for large purchases - like a car or property. The person would then require a wheelbarrow or a truck with security detail to transfer the money and make the transaction. From what I could tell, it was entirely a formality to present social status of wealth with no actual necessity. The other advantage of the mobile payment system was the ability to disguise price fluctuations per person... a hotel room advertises 300 USD per night, but what you pay depends on your relationship to the manager, and no reference to price is ever spoken aloud. I imagine in Somalia that the hard currency will remain only ceremonial (which is expensive) and the central bank will manage exchange with intent that all transactions to remain wireless. BTW - John, the government of Somalia is not strong enough to enforce most laws, let alone currency

In the case of the Somalia shilling - the note is no longer fiat. It has become actual money - you stated it yourself - the 1,000 shilling note - "real" or "counterfeit" is valued at the cost of the paper and ink it is made with. It is valued as a medium of exchange based on its portability, acceptance and the value of the raw material and efforts that went into creating it - just a few cents. This is the true paper equivalent of metal coinage. This is as close to real money as paper can ever get - they've done it - and it works.

"The literature on dollarization teaches us that once the dollar begins to be used by a country...it is very hard to remove it." Not necessarily true: Myanmar had no problem dumping the dollar for the kyat. Plus, you're wrong about Panama: Panama's coins are minted by the U.S. mint. Also, Cambodia uses local currency to make change for dollars in lieu of coins.

Money is whatever people agree to accept and use as money. I don't think it's that surprising that the 'real' currency and the new are seen as equal; why wouldn't they be? The issuing authority behind the original currency no longer exists, the fact that the money came from them is no longer relevant. And the amount of that money is fixed, so if they need more, they make it for themselves. The exchange rate against the dollar is the regulating mechanism.

Do you think deciding to only issue USD denominated coins, instead of its own independent currency, would have a negative effect on the country's fiscal limitations? MMTers consider issuing a currency to be an important part of national sovereignty. Do you think issuing a currency can offer some degree of fiscal flexibility for a nation like somalia, or would it be worse off, due to inflation risks, if it tried to use its own currency as a fiscal tool? What kinds of issues do CBs in these kinds of countries deal with? I imagine that external financial entities, like the IMF, play a significant role. Depending on your perspective that role could be considered friendly support or a continuation of colonization. Do you see any good political reasons to issue your own currency, or are these countries better off if they don't try to undertake that burden?